The changing face of credit
portfolio management at banks
Risk.net August 2023

White paper

Faced with huge increases in capital charges in the coming months, banks will turn to credit portfolio
management to support business decisions on origination, capital allocation and risk transfer

The changing face of credit portfolio management at banks

Contents

2 Introduction

3 The end of the internal model?

About Moody’s Analytics
Moody’s Analytics provides software andsolutions that deliver data, intelligence andexpertise to builds banks’ confidence,
empowering them to make pivotal decisions
and take decisive action to turn their plans
into reality.
To grow with confidence, a solid foundation ofrisk and compliance management is essential –as are tools and processes geared up to spot
opportunities and act on banks’ ambitions.
Moody’s Analytics expertise, packaged
in software, services, data and analytics,
helps banks stay focused on their growthand helps take care of risk, finance andlending processes.

4 Market volatility

4 Risk transfer

6 New economic cycle

6 Long-term and emerging risk
Cover image: Meranna and Nikada/Getty
Published by Infopro Digital© Infopro Digital Risk (IP) Limited, 2023

7 New tools
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The changing face of credit portfolio management at banks

Introduction
The mandate of credit portfolio management (CPM) at banks is set to expand and play a more strategic rolein the coming months as banks grapple with upcoming regulatory changes, increased market volatility anduncertainty in the global economy, say credit, finance and risk experts.
New rules governing banks’ capital requirements – part of a package designed to shore up Basel III – will be
implemented across many jurisdictions in 2025. While there are currently delays in the US, implementation
across the European Union and the UK is scheduled for January 1, 2025. The rules are likely to significantly
increase the amount of capital that banks need to hold. Faced with additional capital charges – which could
run into the billions – banks will need to review their capital allocations, portfolio management and risk
transfer strategies to mitigate some of the impact of these rules. Credit and risk experts suggest CPM willplay a key role in this, supporting businesses with decision-making and having greater input into origination
and balance sheet optimisation in the coming months.
“Firms will be looking very carefully at the way they allocate capital going forward, and the CPM
function is going to play a more important role than has been the case for the past few years,” says
Alexis Hamar, head of banking client relationships at Moody’s Analytics.
Final Basel III reform is being implemented in the EU through the third capital requirements regulation (CRR III),
which reached political agreement on June 27. It marks a much-discussed return to the use of thestandardised approach (SA) – the method set out by the Basel Committee on Banking Supervision
for calculating regulatory capital. Currently, most large banks use their own models under the internalratings‑based (IRB) approach. The new rules restrict the use of internal models and include an output floor
that requires banks to hold capital equal to at least 72.5% of the amount indicated by the SA, regardless ofwhat their internal models suggest.
“The new rules will bring a fresh dimension to the CPM mandate – at least for banks under the
IRB approach,” says Thomas Alamalhoda, head of resource and portfolio management at BNP Paribas.
“Post-implementation, they will have to manage capital under two different paradigms: the standardised
and IRB approaches. This is one of the direct effects of the output floor.”
Changes to the SA – such as adding more tiers, categories and requirements – are also being broughtin, which will make it more risk-sensitive. However, its simplified and standardised nature means it issignificantly less risk-sensitive than banks’ own sophisticated models.
“The SA and the output floor will clearly make the assessment of the real risk more complex,”
Alamahoda says.
The output floor will be phased in, not reaching 72.5% until 2028. By then, almost one-quarter of banks
worldwide are set to be bound by it, up from just 6% at the end of 2021, according to the Basel Committee.
The output floor is expected to increase the Tier 1 capital requirements of large European banks by 17.5%
when compared with levels held at the end of 2021, Basel Committee figures suggest.
The final Basel III rules also introduce a leverage ratio buffer to further limit the leverage of global systemic
institutions by requiring them to keep additional capital in reserve. This will also impact CPM.
“Management of the leverage ratio will require the expansion of the CPM role,” states Alamalhoda. “If you
look at the balance sheet size or the leverage exposure used for the computation of the leverage ratio, themain contributors are businesses from typical global markets activities, namely fixed income, currencies,
commodities and equities,” he says. “On the corporate banking side, tools to manage the leverage exposure
are more limited – aside from asset sales, which have an obvious impact in terms of client relationships.”

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The changing face of credit portfolio management at banks

One of the biggest impacts of final Basel III implentation is the introduction of changes to the methods
and approaches used to calculate risk-weighted assets (RWAs) and capital ratios. All risk types will
be affected, regardless of whether the standardised or IRB approach is being used. Major changes
include reducing the use of the advanced IRB approach for financial institutions and replacing it witheither the foundation IRB approach or the SA. Meanwhile, equity exposures will come out of IRB
scope and only fall under the SA.
“Final Basel III implementation – or CRR III – is a potential game-changer for European banks, as
current distribution of risk weights and profitability by facility or client could totally change,” says
Alamalhoda. “This is a challenge for decision-making processes and drives the need for a double
assessment in terms of economic and regulatory key performance indicators. The good news is thatthe portfolio will not be any riskier, as the risk profile will remain the same,” he adds.
As a result of these changes, affected IRB models will need to be recalibrated and, in some cases,
new regulatory approval will need to be sought.

The end of the internal model?
The new emphasis of the SA under final Basel III reform raises the question of whether banks will still
use internal economic models to calculate capital holdings.
Alamalhoda believes they will. “The new regulatory framework – while aiming at harmonising andsimplifying RWA computation approaches – is not the end of internal models,” he says.
Nick Silitch, former chief risk officer at Prudential, believes the 72.5% output floor still gives large
firms an incentive to model their own portfolios, especially as today’s technology makes it “really not
expensive or time-consuming”.
He says dropping the internal economic model altogether would be a loss for the industry. “Hopefully
there is still room for that economic model because, once you get away from having the economic
model drive your decision-making, you’ve lost a lot.”
For firms still operating internal models, the challenge will be bridging the gap between the
output of economic models and the SA – and, here again, CPM will play an important role, saycredit experts.
“We see it as an important opportunity for CPM to help the institution reduce the gap, when relevant,”
says Alamalhoda. “We are seeing a growing trend of CPM facilitating internal capital reallocation,with savings redeployed into growth plans. Those institutions that have the proper framework for
implementing capital active management strategies will obviously be better placed to tap into thistrend,” he says, adding that BNP Paribas has “extensively invested” in this area.
He adds that it’s important to note the output floor is not applied at asset level, but at institution level:“This means you can benefit from mutualisation effects.”
This may also add complexity, suggests Hamar. “Because of the output floor, banks will now have tomanage and steer their portfolios at a more aggregated level than before.”“Previously, banks could adopt a granular loan-by-loan approach to achieve the most optimal capital
allocation treatment. They will now be required to assess the impact of new loans at portfolio level andconsider how to optimise the existing balance sheet,” he adds.

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The changing face of credit portfolio management at banks“Firms will be looking very carefully at the way they
allocate capital going forward, and the CPM function isgoing to play a more important role than has been the casefor the past few years”
Alexis Hamar, Moody’s Analytics

Market volatility
Increased market volatility and margin call hikes in recent months have made hedging trickier and more
expensive, putting extra emphasis on the role of CPM, say credit experts. While derivatives valuation
adjustment (XVA) desks can take on and hedge some credit risk, the expense of dynamic hedging strategies
can be prohibitive. These days, the credit function may need to be more strategic, says Malcolm Hibbert,
managing director and head of XVA trading at Crédit Agricole CIB.
“You might need to look at how your portfolio is diversified, as opposed to only the dynamic rebalancingof hedges. It’s not just about the capacity to hedge – it’s also about understanding and managing
concentration risks and diversifying.”
Certain concentrations tend to occur naturally in banks’ portfolios. For example, a regional bank in
Houston, Texas, is very likely to be heavy on loans to the oil industry, while a large bank may have aconcentration of assets in the country in which it is headquartered. As credit portfolio managers look at
various portfolio diversification strategies that deal with concentration risk, they also need to consider new
RWAs and increased capital charges. Hamar expects to see a move towards capital steering strategies
such as ‘risk parity’ type strategies, which involve selecting a relatively even spread of medium-risk assets
within the portfolio, in line with risk appetite allocation constraints.
“Another possible strategy is to polarise risks, opting for both light RWA assets – overweighted in relation towhat the institution deems necessary in terms of capital – and high-risk, underweighted assets,” Hamar adds.

Risk transfer
As well as portfolio diversification, credit portfolio managers will be looking to implement new
asset allocation strategies using optimal risk transfer solutions, say credit experts. “If, as a CPM,
you actively manage back-book capital, you will need to reassess your positions to ensure thatsignificant risk transfer [SRT], credit insurance or credit default swap [CDS] positions remain efficient,”
says Alamalhoda. “This could therefore require unwinding some positions and putting on new ones.”
SRT transactions will be key here, says Som-lok Leung, executive director at the International Associationof Credit Portfolio Managers (IACPM).
In the EU, these trades are usually conducted via synthetic securitisations, where a special-purpose vehicle
buys tranched credit protection from investors, referencing an underlying portfolio of the bank’s loans.
SRT deals may be used by banks to reduce exposure to specific sectors, or to obtain more general capitalrelief, because the synthetic securitisation will cut the credit RWAs of the underlying pool.

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The changing face of credit portfolio management at banks“While CDS have diminished in importance since the financial crisis [that began in 2007–08], in Europe,synthetic securitisation is very important as a source of capital relief so that banks can recycle capital to lend
to the real economy,” says Leung. It is gaining importance in North America – particularly Canada – he notes.
“One of the reasons why Canadian and US banks are now looking at it is because they can see what iscoming in terms of potential pressure on regulatory capital and they know how long it takes to get into
this market,” says Leung. “It’s not like going out and buying a credit insurance policy or buying a CDS andhedging it. It involves setting up an entire team and developing a programme.”
It had been feared that CRR III would strangle the SRT market with regulatory treatment that would rendermost transactions uneconomical. However, the June 27, 2023 political agreement of CRR III offered somerelief by amending the ‘P factor’.
Under the final Basel III securitisation rules, banks using the SA have to apply a fixed multiplier known as
the P factor, so securitisation carries a higher risk weight than the underlying asset. Although this is targeted
specifically to the SA, it hits banks deploying the IRB approach due to the 72.5% output floor. Under EU
securitisation rules, the originating bank must retain 5% of the synthetic transaction to protect against
conflicts of interest. The design of the output floor in the original draft of CRR III, published in October 2021,
would have made it prohibitively expensive to hold a retained senior tranche. As the vast majority ofsynthetic securitisation deals have regulatory capital relief, constraining that would have had a huge impact,says Leung.
To address this, the latest agreement included a proposal – known as the Boyer amendment – to halve
the P factor when it is applied to the output floor. This significantly reduces the amount of capital that IRB
banks – by far the biggest issuers of SRT – need to hold against retained SRT senior tranches.
For the minority of SRT issuers that use the SA, however, the Boyer amendment provides no relief, and
SRTs may still be uneconomical unless the issuing banks’ cost of equity is very high. Capital requirements
for retained securitised assets, under the SA, work out between four and seven times higher than simply
keeping the same assets on a balance sheet, according to one industry source.
This runs counter to the goals that European regulators and European Parliament had for securitisation,suggests Leung. “The idea behind the simple, transparent and standardised framework to SRT was to try
and promote more lending to the real economy – especially for small and medium-sized enterprises (SMEs).
But, as far as the SA goes, SMEs – especially high-quality SMEs – will be one of the things hit first. In thecurrent economy, that’s not necessarily what you want to curtail.”
Again, CPM will be required here to optimise risk and profitability within portfolios, taking into account notjust regulatory capital charges, but also today’s new economic paradigms, say credit and risk experts.

“While CDS have diminished in importance since thefinancial crisis, in Europe, synthetic securitisation is very
important as a source of capital relief so that banks canrecycle capital to lend to the real economy”
Som-lok Leung, International Association of Credit Portfolio Managers

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The changing face of credit portfolio management at banks

New economic cycle
Silitch believes more work needs to be done on economic modelling so credit models more closely reflect
the new economic cycle of rising interest rates. “For the past 40 years, interest rates have been pretty muchfalling the entire time, while asset values have been rising,” he says. “All of our default and recovery metrics
are calibrated using data where that tailwind was in existence.”
This means that, even though the data is plentiful and robust, it is flawed in terms of calibrating what a
distribution of outcomes might look like when interest rates are flat or rising. “It is useful for understanding
what the shape of a distribution might look like, but it doesn’t do a good job of defining the tails. Firms
should think about putting a conservative overlay on their credit modelling to compensate for the inherent
biases in the historic data,” he says. “I don’t see much being done on that front yet.”
Another challenge for CPM units is the low correlation between market conditions and regulatory capitalconsumption,” says Alamalhoda. “This is [particularly] true for the assessment of profitability at origination,
where margins or liquidity cost variations are not generally correlated to the regulatory capital charge.”
Taken as a whole, it is expected that final Basel III reform could speed up the disintermediation strategy
across the banking system in Europe. “One can expect some banks may exit certain markets, or at least
accelerate their distribution strategy to decrease their final take,” says Alamalhoda.
This could accelerate the growth of shadow banking. Lightly regulated financial institutions – such as pension
funds – are already at a competitive advantage over banks with large regulatory capital charges. Shadowbanking is also likely to be able to take on certain assets that banks would struggle with under Basel III.

Long-term and emerging risk
As the role of CPM widens, many credit portfolio managers are considering how they will be impacted byemerging and longer-term risks, such as those related to climate.
“Climate risk has already changed business models and, increasingly, it’s going to redefine how the world
works,” says Silitch. “It needs to be considered as firms estimate cashflows.”
In the coming years, firms and assets deemed high climate risk – or that are not compliant with environmental,social and governance (ESG) factors – are likely to receive shorter-term loans at higher rates, say credit experts.
“From a pure credit risk management perspective, companies that are not compliant will see their accessto market and funding potentially reduced,” says Alamalhoda. “As a result, beyond the positive impact on asociety of banks financing ESG complaint actors, there is also a benefit in terms of risk management.”
Leung has also seen CPM at many banks becoming one of the main hubs for looking at ESG and climate
issues as part of the onboarding process. “Climate issues – both risk and financed emissions – havebasically become another dimension for the credit decision,” he says.
Despite challenges around data and the lack of standardisation in corporate climate risk disclosures, banks
are taking early steps in assessing climate risk from a credit perspective. “Firms are starting to incorporate
climate risk factors into strategic planning, credit origination and insurance underwriting, in addition to CPM
and stress-testing scenarios,” says Leung, noting that different firms have different practices. “Some may
try to incorporate climate risk into the credit risk assessment using something like a credit climate risk
scorecard, while other firms take a much more subjective approach.”

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The changing face of credit portfolio management at banks

In time, the integration of climate risk factors into credit decisions will produce internal risk ratings,
which will evolve into climate risk-adjusted ratings. These will allow credit risk to be structured, priced
and managed at an individual borrower level and an aggregated portfolio level, says Leung.
As well as climate risk, Silitch believes firms should keep an eye on the rising level of US debt. Sitting
at around $32 trillion today, US debt is up from $5.7 trillion in 2000, according to US Treasury figures.
The country’s debt-to-GDP ratio has risen from 55% in 2000 to 123% in 2022, putting it way above the
77% mark the World Bank believes is a tipping point for debt slowing economic growth.
“Debt has grown hugely over that time and, at some point, people may start questioning the safety andsoundness of fiat currencies,” says Silitch. “I don’t think the dollar will ever lose [its status as] a reserve
currency, but I think it might lose its exclusive stature.” If that were to happen, volatility would almost certainly
increase and things could move quickly. “It’s worth thinking about what could upset that apple cart,” he says.

“Climate risk has already changed business models and,increasingly it’s going to redefine how the world works ...
It needs to be considered as firms estimate cashflows”
Nick Silitch, Prudential

New tools
The Covid-19 pandemic and the war in Ukraine have provided salutary lessons in how quickly andprofoundly the global economy can be impacted by an event. As a result, many firms are now putting
greater emphasis on early warning indicators, says Hamar.
“Early warning indicators for increased risk in credit positions are being developed to model loan lifecycles,
as well as capturing specific counterparties’ behaviours in a portfolio context,” he says.
These fast-emerging risks also highlighted the importance of banks having near real-time visibility into thecredit risk in their portfolios. As a result, credit portfolio managers now want to understand sensitivities andconcentration risk in real-time and to run sophisticated ‘what-if’ scenarios. Not surprisingly, they are keen toharness the latest technologies for portfolio optimisation.
For several years, cloud computing has allowed firms to tap into vastly greater stores of data and carry out
computationally intensive calculations. More recently, data-intensive techniques such as machine learning
are being used to pull in, organise and analyse reams of data. For CPM, this data consists of internalsources (such as automated client financials and client credit behaviour) and external sources (such as
economic forecasts, rating agency data, newsfeeds and even social media).
A December 2022 survey by the IACPM and McKinsey & Company found that firms tend to use external
data sources for credit analysis on the corporate segments of portfolios and internal ones for SMEs.
In SME portfolios, machine learning models are being used in credit scoring, early-warning-indicator
development and credit pricing, the survey found. In corporate asset classes, their usage is largely confinedto early‑warning-indicator development.

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The changing face of credit portfolio management at banks

When it comes to automating decisions on portfolios, the survey found that only 11% of SME portfolios
and 4% of mid-market portfolios at banks have fully automated decisioning that covers more than 50% of
the portfolio.
Elsewhere, automation technology is helping standardise data and processes across departments, allowing
greater connections between CPM and other departments such as risk, treasury and balance sheet
management. This is helping move it closer to the business and to take on a more strategic role.
The combination of tighter regulation, market volatility and economic uncertainty are putting the spotlighton CPM, increasing its strategic importance and redefining its mandate. With the final Basel III reforms
reducing the sensitivity of RWAs, credit portfolio managers will need to review portfolios and devise
strategies for optimising risk and return. This could range from unwinding some trades to completely
reorganising portfolios to minimise regulatory capital charges.
Meanwhile, changes in the rates cycle and market volatility are increasing credit risk, further triggering
the need for a review of portfolios. However, advances in technology and data-intensive analytics can
support more sophisticated CPM strategies than ever before. Carrying out this analysis, backed up
by new technologies such as machine learning, will take the CPM function to the next level. This will
ensure its readiness for the next big event while, at the same time, raise the profile of CPM within theentire organisation.

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